EY ITEM Club Special Report on the Labour Market

May 2017

EY 1

Contents Foreword 2

Highlights 4

1. Recent trends in the labour market 5

2. Explaining developments in employment and pay 7

3. Prospects for the labour market 11

4. Conclusions 16

EY is the sole sponsor of the ITEM Club, which is the only non-governmental economic forecasting group to use the HM Treasury model of the UK economy. Its forecasts are independent of any political, economic or

business bias.

Foreword

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Mark Gregory

EY Chief Economist UKI @MarkGregoryEY

Where next for the labour market?

The strong labour market has been key to recent economic performance

The labour market has had a major influence on UK economic performance in recent years with increasing levels of employment supporting growth in consumer spending. However, this employment growth has not been accompanied by wage growth at the rate we would have expected based on historic relationships between the level of unemployment and pay. The UK’s productivity performance has also disappointed.

Looking forward, Brexit, technological change, demographics and Government policy could all potentially disrupt the UK labour market the environment businesses find themselves in. This latest EY ITEM Club special report on the labour market is therefore particularly timely, providing an in-depth analysis of the factors that will influence the future structure and size of the market.

Signs of a slowing jobs market…

The rate of joblessness, as measured by the Labour Force Survey (LFS), of 4.7% in February 2017 was the lowest since 2005 and at a level only rarely achieved in the last 40 years. However, the rate of growth in employment has been slowing and in the last quarter of 2016 was only half the rate of the previous year.

…and no signs of a significant uptick in pay…

The failure of pay growth to accelerate in the light of falling unemployment is ostensibly hard to explain. Pay increases have remained stubbornly anchored between 2% to 3% for the majority of the period since 2010. In September 2005 when unemployment was at similar levels to the present day, average earnings were increasing by almost 5% year-on-year.

…leave us working to understand what is driving the market…

The EY ITEM Club identifies a number of reasons for the change in the relationship between levels of unemployment and pay:

Lower productivity may have played a part as real wage growth and productivity improvements have historically gone hand-in-hand;

A decline in the ‘equilibrium’ unemployment rate as a result of increasing labour market flexibility and the growth of self-employment;

Increased slack in the labour market with more than twice the number of officially unemployed people wanting more work;

Fore

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Foreword

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Growth in labour supply due to a higher number of older people in the workforce and increased migration;

The impact of austerity reducing public sector pay; and

Shifts in the sector mix and the composition of employment, including a decline in higher paid jobs.

It is clear that there is no simple explanation for the changing nature of the UK labour market. This means that businesses cannot assume that current conditions will continue into the future, especially as other factors may come into play.

…and how market conditions will evolve in future…

As the recent EY ITEM Club Spring forecast showed, the UK economy is starting to slow. This will lead to a reduced demand for workers, with the EY ITEM Club forecasting employment to rise 0.6% in 2017 and then fall 0.1% in 2018 compared to growth of 1.4% in 2016. Softer demand is likely to be matched by softer supply, as a consequence of demographic change and reduced migration levels, even before Brexit, reflecting changes in the relative economic performance of the UK and the EU. Unemployment is forecast to edge upwards, reaching 5.8% on the LFS measure in 2019.

The impact of Brexit is currently difficult to predict as detailed negotiations on the terms of the UK’s exit have yet to begin. Similar levels of uncertainty surround the impact of technology on employment, with a wide range of views on both the potential size of any effect and the time period over which this will occur. The EY ITEM Club cites two studies which suggest the number of jobs at risk from automation ranges from 9% of the total to 47%.

…and so close attention to market developments is essential.

The labour market has surprised most observers in recent years so there may well be more surprises to come. Businesses need to monitor developments in employment levels and pay at the macro level to identify potential shifts in the market and to use this to drive deeper analysis of the implications for their businesses.

Key areas to focus on are:

Assessing the future demand for labour covering roles and skills and identifying potential areas that could be impacted by changes in labour supply especially due to Brexit, such as a reduction in skilled workers in specific areas currently sourced from EU countries, and developing contingency plans.

Monitoring developments in pay for specific roles and skills to ensure that reward levels remain competitive and to identify potential risks to margins from pockets of wage inflation.

Evaluating the case for investing more in skills development and training to improve the contribution of the existing workforce, encourage retention and potentially address emerging labour supply gaps and wage pressures.

Continuing to review the potential to use technology to reshape the workforce across the business.

Tracking the progress of the Taylor Report on employment which may have significant implications for the classification of employees and hence the economics of certain segments of the labour market.

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Highlights

► The UK labour market is set to face a rockier period than of late over the next few years. Pay growth seems unlikely to break out of the subdued pace seen since 2010, while the compensation to household incomes offered by increasing numbers of people in work looks set to fade as the consequences of a slowdown in economic growth bite.

► The jobs market has stuck to a familiar and two-sided theme in recent years. On a positive note, steadily rising employment and falling unemployment have yielded a jobless rate that has rarely been lower at any point in the last 40 years as well as a record number of people in work. But this has yet to translate into any meaningful boost to pay growth.

► Developments in the structure of the jobs market resulting in a decline in the ‘equilibrium’ rate of unemployment appear to be a key driver of the apparent jobs/pay paradox. A shift towards less secure and, on average, less well-paid, part-time and self-employed jobs may have dampened workers’ willingness to push for higher wage demands. The tightening up of benefit eligibility has increased pressure on the jobless to find work. And there have been favourable supply-side developments flowing from migration and more participation by older people in the workforce.

► Meanwhile, the official roll of joblessness disguises the true amount of slack in the labour force. A broad measure of un- or under-employment yields a figure close to 5m people, three times the number officially registered as unemployed.

► The pace of improvement in the jobs market has recently shown signs of losing steam. In explaining why, the labour market may simply be a victim of its own success. As the proportion of people in work has climbed ever higher, firms may have found it more difficult to fill vacancies, resulting in greater utilisation of existing workforces and slower jobs growth.

► But developments in the wider economy are probably playing a role. While economic activity has held up better than many expected since last summer, there are signs, particularly in the consumer sector, that the pace of expansion is slowing. This will mechanically feed into weaker demand for workers. Having risen by 1.4% in 2016, we expect the number of people in work to increase by a modest 0.6% this year, before shrinking 0.1% in 2018. This would be the first fall in employment since 2009.

► But the consequences of softer labour demand for the unemployment rate will be cushioned by slower growth in the supply of workers, as an ageing population and lower levels of migration exert their effects. The LFS jobless rate is forecast to rise from 4.8% this year to 5.4% in 2018 and 5.8% the following year. This would be broadly in line with rates seen in the early 2000s.

► The prospect of an uptick in unemployment, partially reversing the fall in joblessness towards its equilibrium level, will hold pay growth down, as will extra costs faced by employers arising from rising input costs, the introduction of the apprenticeship levy and the ongoing expansion of pensions auto-enrolment. Increased automation, exacerbating the ‘hollowing out’ of the jobs market is a more ambiguous risk. But there are some potential upsides. Companies may choose to share buoyant profitability with workers. And further increases in the National Living Wage will provide a modest impetus to total pay growth.

► For companies, a continuation of low wage growth will, in some respects, be good news for bottom lines. But the corollary of stagnation in workers’ spending power – weaker domestic demand – won’t be helpful. Meanwhile, the adverse effect of developments in demographics and migration on labour supply may compel more focus on investment in capital equipment and the training and development of existing workforces. Indeed, our own forecast shows GDP growth of 1.2% in 2018 being more than accounted for by an increase in productivity. Among the clouds surrounding the UK’s jobs outlook, there may be some silver linings.

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The story of the UK jobs market has been a remarkably consistent and strikingly two-sided one in recent years. On the one hand, steadily-falling unemployment, rising employment and continued strong demand for workers - as witnessed by climbing job vacancies - have all been sources of cheer. But, on the other, a stubborn refusal of pay growth to respond to what, on the face of it, has been an economy moving ever-closer to ‘full-employment’, and the failure of productivity growth to recover to the pre-financial crisis norm, have continued to arouse concerns about the true health of the UK’s labour market.

Recent months have generally delivered more of the same as far as these trends are concerned. However, the underlying currents in the labour market have shown signs of shifting, with the rate of improvement in the various gauges of jobs performance slowing. And the most prominent economic development of the last six months or so – the revival of inflation and the squeeze rising prices are exerting on households’ spending power – threatens to exacerbate that slowdown. This Special Report looks at how serious that threat is. It begins by setting out recent developments in the jobs market, before considering why employment and pay growth have evolved in the apparently paradoxical manner of recent years. The Report then considers the outlook for the jobs market, set against our expectations for the economy and likely underlying trends such including the advance of technology and robotisation.

1. Recent trends in the labour market

The jobs market stands strong, but pace of improvement has slowed…

Over a range of labour market metrics, the UK jobs market currently appears to stand in a very strong position. As of the three months to February 2017, the Labour Force Survey (LFS) measure of the unemployment rate stood at 4.7%, the joint lowest since mid-2005 and well below the 7.1% averaged since the LFS series began in 1971. Joblessness has only been below this rate for a few months in the last 40 years. Short-term unemployment (those out of work for six months or less) was at a record low (since data began in 1992). Meanwhile, job vacancies sat at almost 770,000, a record high and 75% up on the recent nadir reached in the recession of 2008-09. The employment rate also scored a record high of 74.6% and the ratio of unemployed people to job vacancies sat at 2.03, a record low.

But a positive story in terms of levels disguises a falling off in the rate of improvement in the jobs market. For example, in the last quarter of 2016, total employment was up by 1% on the previous year, only half the pace of 12 months earlier and even further short of the recent peak of 2½% seen in early 2014. On the same theme, the number in work grew by only 30,000 in the six months to February 2017, a fraction of the 300,000 jobs created in the first half of 2016 and the smallest rise over any six-month period in almost four years.

…and pay growth has remained unresponsive to falling unemployment

Moreover, historically favourable levels of unemployment and employment still haven’t been accompanied by what would typically follow from an ostensibly tight jobs market – accelerating pay growth. Annual growth in average weekly earnings has shown no sign of breaking out of the 2-3% range evident, with rare exceptions, since 2010, with the three months to February delivering a year-on-year rise of 2.3%. The last time the unemployment rate was at low as it is at present, in September 2005, average earnings were increasing by almost 5% year-on-year. Moreover, there is little sign that this year will deliver a sea-change in pay performance. According to the Bank of England’s regional agents, pay settlements in the early part of the year (an important period for many firms in the pay calendar) have been clustered around 2 to 2½%.1

And in real terms, the picture has looked even gloomier. With inflation climbing but growth in cash pay muted, real earnings broadly stagnated in early 2017 compared to the level a year earlier. This was a marked shift from the 1-2% growth seen in 2014-16, a period when, thanks to ‘lowflation’, real rises in earnings looked like returning to the pre-financial crisis norm.

1 Bank of England ‘Agents’ summary of business conditions 2017 Q1’, February 2017. http://www.bankofengland.co.uk/publications/Documents/agentssummary/2017/feb.pdf

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Sectoral performance has been far from uniform

Moving from the aggregate to the sectoral level, most industries have shared in the general buoyancy of the jobs market. Fuelled by a rising population and an increased appetite among consumers to eat out, the biggest absolute source of jobs growth between the beginning of 2010 (just after the conclusion of the last recession) and the end of 2016 has come from pubs, restaurants and catering firms (recording a rise in headcount of 259,000, or almost 18% on the Q1 2010 level). This was followed by office administrators and business support staff (growth in employment of 213,000 or 60%), and the activities of head offices and management consultancies (a rise of 198,000 or 36%).

But some industries have shed workers over the same period. Among those sectors, the consequences of government action to cut the fiscal deficit have been very evident in a decline in employment in public administration and defence. This recorded the largest absolute drop in headcount, a fall of 267,000 or 17.5% in the seven years to the end of 2016. Meanwhile, the after-effects of the banking crisis are visible in a 53,000 (9.5%) shrinkage in jobs in the financial sector.

Our last Special Report on the labour market, published two years ago, noted a growing degree of polarisation in the jobs market in the four years or so following the end of the 2008-09 recession.2 In terms of occupation, a marked shift had occurred away from middle-skill level jobs (typically clerical and manufacturing), towards high- and low-skilled jobs. And the latest numbers, extending this analysis up to the end of 2016, show a continuation of this trend. High-skilled occupations (encompassing managerial, professional and associate professional roles) accounted for two-thirds of

2 EY ITEM Club, ‘Special report on the labour market’, February 2015. http://www.ey.com/Publication/vwLUAssets/EY-ITEM-Club-Special-Report-on-Labout-February-2015/$FILE/EY-ITEM-Club-report-on-labour.pdf

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UK: Change in employment by occupation, Q1 2010 - Q4 2016 '000s

Source : EY ITEM Club, ONS

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Low skill

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Public administration and defence

Financial services

Recording

Publishing

Washing and dry-cleaning

Electronics manufacturing

Security and investigation activities

Employment activities

Health

Computer program. & consultancy

Retail

Head offices & man. consultancy

Office admin & business support

Food and beverage service activities

UK: Changes in employment by selected industry, Q1 2010- Q4 2016

'000sSource : EY ITEM Club, ONS

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the rise in total employment from Q1 2010 to Q4 2016. A further 32% of the increase was represented by low-skilled occupations. But middle-skill level jobs accounted for a negligible 0.8% share, probably reflecting the greater ease with which these roles can be automated or offshored as well as a general upskilling of the workforce.

And these developments appear to have speeded up more recently. In the 12 months to the end of 2016, high- and low-skilled jobs increased by 3.3% and 0.9% respectively but middle-skill level jobs shrunk by 3.3%. So the ‘hour-glass’-shaped employment profile identified in our last report has become even more accentuated.

2. Explaining developments in employment and pay

Is the jobs market a victim of its own success?

Overall, the UK labour market represents something of a ‘curate’s egg’ – impressive in many respects, but displaying some concerning features. That said, in accounting for the observed slowdown in the pace of improvement over the course of last year and into this, the jobs market may simply be a victim of its own success. As the proportion of people in employment has climbed ever higher, firms may have found it more difficult to fill vacancies, resulting in greater utilisation of existing workforces and slower jobs growth. This is certainly consistent with the current record number of job openings and with recent developments in hours worked. The average number of hours worked per week reached 32.4 at the beginning of 2017, a 15-year high and 1.7% up on a year earlier.

However, a shortage of workers would be expected to bring forth faster pay growth. But rises in average weekly earnings have continued to display remarkably little sensitivity to a low, and still falling, rate of unemployment. Consider 2005, the last time the UK saw unemployment at the current rate of just below 5% (on the LFS measure), as well as the last occasion to see the ratio of unemployed people to vacancies close to being as low as it is at present. Back then, annual growth in average weekly earnings was running at 4½% to 5½%, around double the current pace. Prior to the mid-2000s, it is necessary to go back 20 years further, to the mid-1970s, to see unemployment at a similarly low rate. At that time pay was surging by over 20% year-on-year.

No doubt, exceptionally high inflation played a role in driving such hefty wage rises. And a steady downward trend in inflation for a given rate of unemployment over the last 30 years has accompanied the slowdown in pay growth. But the explanation of falling inflation leading to falling pay growth carries less weight in explaining more recent developments. Statistical research relating to the post-2000 period has failed to establish a convincing chain of causation from low inflation to slower rises in earnings.3 And that chain is not clear-cut. Weak pay growth may have contributed to falling inflation as much as the reverse. Moreover, since 2010, average pay rises have been consistently weak and undershot forecasts from the consensus of economists and the Bank of England in periods of both relatively high inflation (2011-12), and very low inflation (2014-2016).

An alternative explanation attributes the weakness of pay to a period of unusually low productivity growth. Historically, there has been a close relationship between growth in real pay and productivity. A link from the latter to the former is not difficult to theorise – if workers produce less output for firms, then in a competitive market firms will only be willing to employ them at a lower wage. But the chain of causation may also have run in reverse – weakness in pay could have lifted the demand for workers in labour-intensive sectors (which typically have low average levels of pay and productivity) and

3 See page 5 of ‘The labour market’. Speech given by Michael Sanders, External MPC Member, Bank of England, 13 January 2017. http://www.bankofengland.co.uk/publications/Documents/speeches/2017/speech953.pdf

31.0

31.5

32.0

32.5

33.0

33.5

66

67

68

69

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71

72

73

74

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76

1993 1996 1999 2002 2005 2008 2011 2014 2017

Employment rate (LHS)

Average hours worked per week (RHS)

UK: Employment & hours worked%

Source : EY ITEM Club/Haver Analytics

Hours

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encouraged the substitution of labour for capital. Indeed, recent work by the Bank of England found that a slowdown in ‘capital deepening’ (a rise in the amount of capital per worker) can explain nearly two-thirds of the gap between the actual level of productivity from 2011-2016 and the much higher level implied by the long-run pre-financial crisis trend.4

The ‘equilibrium’ unemployment rate appears to have declined…

In practice, developments in the structure of the jobs market appear to be the key driver of weak pay growth, resulting in a decline in what is termed the ‘equilibrium’ rate of unemployment. The equilibrium rate can be defined as that which generates a rate of pay growth consistent with achieving the Bank’s inflation target (so with an inflation rate of 2% and productivity growth at the long-run average of 2%, pay growth of 4% would be consistent with on-target inflation). A drift down in estimates of the equilibrium rate has been evident among forecasters. For example, the Bank of England cuts its estimate of the equilibrium measure from 5% to 4.5% in February’s Inflation Report. This followed earlier reductions – a look at the (albeit limited) run of published estimates shows that the Bank judged the equilibrium rate to be as high as 6.6% at the beginning of 2013.5

Multiple potential reasons lend themselves to explaining the weakening link between pay and unemployment and a lower equilibrium rate. The first is a more flexible jobs market, with a shift towards less secure and, on average, less well-paid, jobs.6 Taking the two years to the end of 2016, almost a third of the rise in the number of people in work reflected growth in self-employment (double the share of that category in total employment), with another fifth corresponding to more people in part-time work. Over a longer time-frame encompassing the financial crisis and its aftermath, the number of full-time employees ended 2016 3.6% higher than the level at the beginning of 2008. But the number of part-time employees was 8% up and the number in self-employment had expanded by 23%.

4 Bank of England, ‘Bitesize: Correction to ‘There are two productivity puzzles’’, Bank Underground blog, 29 March 2017. https://bankunderground.co.uk/2017/03/29/bitesize-correction-to-there-are-two-productivity-puzzles/ 5 See Section 3 of Bank of England, “Inflation Report”, February 2015. http://www.bankofengland.co.uk/publications/Documents/inflationreport/2015/feb.pdf 6 See ‘The income of the self-employed’. Department for Business, Innovation and Skills, February 2016. https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/500317/self-employed-income.pdf

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Outturn

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UK: Wage growth outturn & Bank forecasts % year

Source: EY ITEM Club/Bank of England

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Average real wage

UK: Productivity & real wagesQ1 2000 = 100

Source : EY ITEM Club/Haver Analytics

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UK: Change in employment since Q1 2008'000s

Source : EY ITEM Club/Haver Analytics

Self-employed

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While these movements may, in part, reflect an increased preference among workers for flexibility and autonomy, it could also stem from cost-cutting by employers. Employing workers on a part-time basis saves on national insurance contributions (NICs), while using self-employed contractors avoids employer NICs and the need to pay the minimum wage or, for those aged 25 and older, the National Living Wage. It also reduces job security, potentially dampening workers’ willingness to push for higher wage demands.

…with headline numbers exaggerating true strength of jobs market

That said, insecurity stemming from shifts in the nature of employment should be mitigated by the sense of security engendered by low unemployment. But simply looking at the official roll of joblessness disguises the true amount of slack in the labour force. As of the three months to February 2017, there were 1.6m people officially registered as unemployed. But 2.2m people classified by the LFS survey as being inactive said they wished to work and a further 1m part-time workers were in that positon because of the inability to secure a full-time position. This added up to almost 4.8m ‘frustrated workers’, three times the number officially registered as unemployed and around 12% of the working-age population. And unlike the number of unemployed, the size of this broader category has remained above the immediate pre-crisis level (4.5m in late-2007).

A misleading message may also be sent out by the current record high level of job vacancies. The collapse in the cost of recruitment advertising arising from a shift from print to on-line ads means that the level of job vacancies, if not the rate of change in openings, may not be as good an indicator of the demand for workers as in the past. Firms may be willing to post more job vacancies on a speculative basis, meaning that the current record level of openings may be sending an overly-rosy view of the demand for workers.

Meanwhile, a tightening up of benefit eligibility has increased pressure on the jobless to find work and may have cut the ‘reservation wage’ of the unemployed (the lowest wage at which a potential worker would be willing to accept a job). As of the end of 2016, only half of those registered as officially unemployed were in receipt of Jobseeker’s Allowance or its successor benefit, Universal Credit. This compares with 60% five years earlier and a peak of almost 98% in the late 1980s.

The supply of workers has seen some favourable developments

A step change in growth in labour supply, driven by increasing numbers of older people remaining in or re-joining the workforce and high levels of migration, may also have acted to depress pay growth. Simple economic theory tells us that an increase in the supply of a factor of production typically depresses its price. And on some measures, labour supply has picked up in recent years. The participation rate (the proportion of those aged 16 and older either in work or looking for work) reached 63.6% at the end of last year, up from 63% in 2012 and only a touch down on the record high reached in the third quarter of 2016.

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2004 2006 2008 2010 2012 2014 2016

UK: 'Frustrated workers'000s

Source : EY ITEM Club/Haver Analytics

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Working part-time but want a full-time job

Economically inactive but wish to work

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Rising participation has been aided by a greying of the workforce. Reflecting rising life expectancy and better health, as well as increases in the female state pension age, participation by those aged 50-64 was 73.3%, compared to 67.6% at the beginning of 2008, while over the same period, the proportion of those aged 65 and older in the workforce climbed from 7.3% to almost 11%. And recent years have seen more people move into employment from inactivity than from unemployment, demonstrating that potential workers constitute far more than just those categorised as jobless.

Meanwhile, net inward migration to the UK has steadily climbed, reaching almost 350,000 in 2015 compared to a long-run average (since the early 1960s) of just over 60,000. With migrants disproportionately of working age, sizeable inflows of people have been reflected in the employment numbers. In fact, people born outside the UK accounted for more than the entirety of the rise in employment in the year to Q4 2016 (employment among UK-born residents fell by 120,000, but rose by 431,000 for the foreign-born group) and for more than half of the rise over the preceding five years.

…although effect shouldn’t be overegged

However, the nature of the jobs market means that the norm of increased supply/lower price may not be so clear-cut in the case of workers. To the extent that an increased supply of workers brings forth higher employment, more people in work should ultimately bolster the demand for labour, since this implies more spending in the economy on goods and services, resulting in more job creation.

That said, this mechanism may be interrupted in the case of migrant workers by remittances paid to migrants’ home countries. These are estimated to be anywhere in the region of £1.5bn to £16.5bn, or around 0.16% to 1.7% of the UK’s total annual pay bill.7 So the extra supply of workers arising from migration may not fully pass into higher demand, implying some downward pressure on wages, although the consensus of studies suggest that the impact is very small (at least measured in terms of the hourly pay of full-time employees).8

7 The Migration Observatory at the University of Oxford, “Migrant Remittances to and from the UK”, March 2016. http://www.migrationobservatory.ox.ac.uk/wp-content/uploads/2016/04/Briefing-Migrant_Remittances.pdf 8 For example, see Stephen Nickell and Jumana Saleheen ‘Staff Working Paper No. 574 The impact of immigration on occupational wages: evidence from Britain’, Bank of England, December 2015. http://www.bankofengland.co.uk/research/Documents/workingpapers/2015/swp574.pdf

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1964 1970 1976 1982 1988 1994 2000 2006 2012

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Source : EY ITEM Club/ONS

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Source : EY ITEM Club/Haver Analytics

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2002 2004 2006 2008 2010 2012 2014 2016

UK: Job market flows000s

Source : EY ITEM Club/ONS

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More broadly, annual average growth of 0.8% in the workforce since 2010 has actually been little different from that seen in the decade or so prior to the financial crisis (0.9% a year from 1998 to the end of 2007), a period when the norm for pay rises was, as highlighted earlier, much stronger. In practice, compared to that earlier period, rising migration and increased participation by older people was just enough to compensate for the consequences of an ageing population in dampening growth in the indigenous workforce.

And growth in the supply of workers has shown signs of slowing as of late. For example, the 205,000 increase in the economically-active population over the course of 2016 was less than half the 414,000 rise in the previous year. Having helped to drive past rises, the recent slowdown partly reflected a fall in activity rates among those aged 65 and older. And there is some evidence that the attractiveness of the UK as a place to work for foreign citizens may have diminished. The number of foreign-born workers in employment dropped by 9,000 in the last quarter of 2016 on the previous three months, compared to an average rise of almost 150,000 in the first three quarters of the year. That said, year-on-year, the number of foreign-born workers was up by 8.4% in Q4. This was the joint biggest rise since the beginning of 2011. In comparison, employment of UK-born workers fell by 0.5% over the same period.

Compositional and sectoral effects have also been factors

Compositional effects have been a particularly important drag on pay growth across many of the major economies since the global financial crisis, with the impact in the UK being particularly marked. This phenomenon reflects the disproportionate entry to the workforce of low-wage workers and/or exit of highly paid workers, which has the effect of pulling down aggregate measured wage growth. Several factors could be responsible for these effects. A vestige of the global financial crisis may be at play, with the re-entry of workers being more drawn-out than after previous downturns and returnees forced to accept large wage cuts. It could also be that firms were not able to reduce labour costs as much as they wanted during the crisis, meaning that the adjustment was dragged out over time. Demographics could also be a factor here, with baby-boomers having been forced to delay their retirements as the financial crisis reduced the value of their investments, but then leaving the workforce in greater numbers as the legacy of the crisis faded. Work by the Bank of England9 found that these compositional effects could have lowered UK wage growth by up to 1 percentage point at their peak in 2014-15.

Total pay growth has also been subdued by the impact of austerity on public sector wages. Since the emergency Budget of June 2010 which marked the start of austerity, public sector wage growth has averaged just 1.5% per year, well short of the 4% average for the decade before. Rises in private sector pay have hardly been stellar, averaging just 2% a year since mid-2010. But the drag from the public sector has probably had an indirect influence here too, due to ‘benchmark’ effects, where private sector salaries are set partly with reference to those on offer in the public sector.

3. Prospects for the labour market

A slowing economy will affect the jobs market…

While economic activity has held up better than many expected since last summer, there are now signs, particularly in the consumer sector, that the pace of expansion in the economy is slowing. For example, Q1 2017 saw the first quarterly drop in retail sales volumes since the end of 2013. And business

9 Will Abel, Rebecca Burnham and Matthew Corder, ‘Wages, productivity and composition of the UK workforce’, Bank of England Quarterly Bulletin 2016 Q1, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2016/q1pre.pdf

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2002 2004 2006 2008 2010 2012 2014 2016

Private sector Public sector

UK: Headline average weekly earnings% year

Source : Haver Analytics

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investment fell by 1.5% in 2016, the first calendar-year drop since 2009 (although a sharp decline around the turn of 2015-16 was responsible for much of the fall).

Granted, we expect this year to deliver the same 1.8% rate of GDP growth that was achieved in 2016. But this disguises an expected slowdown over the course of the year, as the squeeze on spending power from higher inflation bites and the boost to the tradable sector from the weak pound and a more buoyant world economy provides only partial compensation. With base effects kicking in as the economy moves into 2018, growth in that year is forecast to slow to 1.2%. The slowdown in activity growth will mechanically feed into weaker demand for workers. So having risen by 1.4% in 2016, we expect the number of people in work to increase by a modest 0.6% this year, before shrinking by 0.1% in 2018. This would be the first fall in employment since 2009.

But growth in the supply of workers is also expected to slow. Further population ageing will make its presence felt, with labour market participation still substantially lower amongst those close to the state pension age (SPA) than amongst younger individuals (although the jobs-market effect of demographic change will tempered by the rise in the SPA to from 65 to 66 due to take effect between the end of 2018 and 2020).

And migration levels may well drop, as the economic revival in the euro-zone and uncertainties flowing from the Brexit negotiations make the UK a relatively less attractive destination for foreign workers, particularly from EU member states. There has been a strong association between the level of net immigration from the EU and the unemployment rate in the UK versus the rest of the EU. With unemployment rates elsewhere in the EU generally on a downward trend, this implies a reduction in net inflows to the UK. Furthermore, the sharp depreciation of the pound has significantly reduced income differentials between the UK and other countries, particularly those in central and eastern Europe, from which levels of migration have been particularly high. This is likely to both discourage migrants from moving to the UK and make it more attractive for those who have migrated from those countries over the past decade to return home. Overall, growth in the economically active population is forecast to slow from 0.9% in 2016 to 0.4% this year, before averaging the same pace in 2018-20.

As a result, the consequences of weaker labour demand for the unemployment rate will be cushioned. We expect the LFS rate to rise from 4.8% this year to 5.4% in 2018 and 5.8% in the following year, before subsequently beginning to drift down again. This would be broadly in line with rates seen in the early 2000s.

…although softer labour supply may spur faster productivity growth

On a positive note, slower growth in the workforce may deliver a boost to what has been a long period of insipid productivity growth. With the flow of potential workers slowing, firms will have more incentive to invest in improving efficiency or labour-saving technology. The potential for the growth-sapping effects of slower labour force growth to be compensated for by higher productivity is supported by recent research on the relationship between population ageing and economic growth. Countries experiencing

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3

4

5

6

7

8

9

2004 2006 2008 2010 2012 2014 2016 2018 2020

UK: Unemployment rate%

Source : EY ITEM Club

Claimant count

ILO

Forecast

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more rapid ageing were found to have grown more quickly in per capita terms in recent decades, possibly due to the more rapid adoption of automation.10 Our forecast is consistent with this notion, with GDP growth of 1.2% in 2018 more than accounted for by an increase in productivity (albeit with projected productivity growth remaining well short of the 2% annual rise that was the norm before 2008).

Prospects for pay look gloomy…

The prospect of a boost to productivity growth and the extra resources this provides firms offers one upside risk to prospects for pay. But pay growth will struggle in the face of headwinds, including the structural developments highlighted earlier and the persistence of low public sector pay awards. What’s more, extra costs faced by employers arising from April’s introduction of the apprenticeship levy and the levying of NICs on termination payments, along with the ongoing expansion of pensions auto-enrolment, are likely to be at least partly passed through to workers, depressing pay growth. The OBR estimates that the apprenticeship levy and auto-enrolment will reduce average earnings by 0.7% by 2020-21.11

In practice, given how unresponsive earnings have been to an unemployment rate which is presently only marginally above the Bank’s estimate of a 4.5% equilibrium, there seems a compelling case that the equilibrium rate is lower. Hence, the prospect of an uptick in unemployment, partially reversing the fall in joblessness towards its equilibrium level, risks pushing pay growth down.

This would certainly be consistent with the trend that has been evident for several decades. Since the 1970s, pay growth has fallen during periods of economic weakness. But the trend over subsequent recoveries has been one of broad stabilisation rather than a rise back to the pre-recession norm. In number terms, having run at around 9% per year during the 1980s expansion, growth in average weekly earnings fell to half this rate during the recession of the early 1990s. Pay growth then stuck at that level, averaging 4.2% from 1992 to 2007, despite a steep drop in unemployment, before halving again during the financial crisis. Since the end of 2009, average earnings have risen by only 1.9% per year. So the 30-year downward trend in earnings growth and the inability of lower joblessness in recent recoveries to lift growth back to pre-recession norms presents two more reasons to think that the current softness of pay growth may persist.

…with increasing automation a potential drag on pay rises

Technology is a possible third, at least over the longer-term. A pessimistic view posits that as technology and machines displace workers, the digital revolution effectively boosts the supply of labour, putting downward pressure on wages in more labour-intensive and low-productivity sectors where machine advances are less applicable. So continued advances in technology imply continued weakness in pay growth in those sectors. This could also be bad news for productivity, since cheaper workers will encourage the expansion of low-productivity occupations, hurting aggregate output per worker, and reduce the incentive to invest in new labour-saving technology.

10 Daron Acemoglu and Pascual Restrepo, ‘Secular Stagnation? The Effect of Aging on Economic Growth in the Age of Automation’, 12 January 2017, National Bureau of Economic Research. https://economics.mit.edu/files/12536 11 Office for Budget Responsibility, ‘Economic and fiscal outlook’, November 2016. http://cdn.budgetresponsibility.org.uk/Nov2016EFO.pdf

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1951 1957 1963 1969 1975 1981 1987 1993 1999 2005 2011

Averageweeklyearnings (LHS)

Unemploymentrate (RHS)

UK: Unemployment & pay growth% year

Source : EY ITEM Club/Haver Analytics & Bank of England

%

Shaded areas indicate recessions

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The counter-argument would ask why several centuries of technological progress have, until very recently at least, generally been accompanied by rising wages across the board. Moreover, there has been no long-run upward trend in the unemployment rate over the last century, despite massive gains in technology.

Certainly, continued rapid advancement in technology and innovation will allow those whose skills are complementary to such advancements to reap the rewards, implying that the aggregate effect on the jobs market may be modest. But the same developments point to mid-skill level jobs experiencing a continued relative squeeze in both numbers and pay as, for example, routine white collar and skilled manufacturing jobs become more vulnerable to automation. According to research by the University of Oxford, jobs are at high risk of being automated in 47% of standard occupational categories, including many white-collar areas (see Table to the left).

Admittedly, other research, which focuses on tasks rather than occupations, suggests that the risk of automation has been overstated. Occupations at high risk from technology may still encompass a large share of tasks that are hard to automate. From a task perspective, the OECD finds that only 9% of jobs in the US are at risk from automation.12

Moreover, if further automation boosts productivity and aggregate incomes and creates the space for

people to specialise in new occupations, the market for mid-level jobs may be bolstered by occupations that are, as yet, unappreciated or even unknown – emotional and relational-based work has been cited by some as examples.13 However, the workforce will take time to adapt to the skills necessary to do these jobs and society to the cultural norms to demand them. So the polarisation in the jobs market that has been very evident in recent years, and the negative implications this carries for more vocationally-minded, may well intensify, at least in the foreseeable future.

…although there are also some potential tailwinds

Technological advances represent a factor which will continue to affect the jobs market for decades to come for good and ill. In the nearer-term, we can point to some positives for the pay outlook. Rising inflation may compel some firms to offer more generous pay settlements (although at the same time, the rising cost of imported inputs may weaken employers’ willingness to countenance higher pay demands). Surging export revenues flowing from sterling’s weakness and buoyant profitability among UK companies more generally might be shared with employees. The ratio of profits to GDP (excluding oil companies) in the last quarter of 2016 was the highest since 2000. And the return on capital for non-oil non-financial companies in 2016 was the highest since 1998.

In addition, we have seen evidence of greater labour market ‘churn’ of late and this tends to be associated with higher pay growth. One of the features of the post-financial crisis period was a marked decline in the number of people moving jobs, presumably due to the perception that there was a greater risk of subsequently losing their job if they moved to a new role than there was if they remained in their existing role. Low levels of churn remained a feature for some time after the crisis, not just in the UK but across the world, but the situation has turned around sharply of late, with the number of workers

12 Melanie Arntz, Terry Gregory and Ulrich Zierahn ‘The Risk of Automation for Jobs in OECD Countries: A Comparative Analysis, OECD Social, Employment and Migration Working Papers. http://www.oecd-ilibrary.org/docserver/download/5jlz9h56dvq7-en.pdf?expires=1493023722&id=id&accname=guest&checksum=74A99F3D1D1B6136781496A45669A913 13 The Economist, ‘The onrushing wave’, 18 January 2014. http://www.economist.com/news/briefing/21594264-previous-technological-innovation-has-always-delivered-more-long-run-employment-not-less

Probability that computerisation will lead to job losses within the next two decades

Job Probability

Recreational therapists 0%

Dentists 0%

Personal trainers 1%

Clergy 1%

Chemical engineers 2%

Editors 6%

Firefighters 17%

Actors 37%

Economists 43%

Commercial pilots 55%

Machinists 65%

Word processors & typists 81%

Estate agents 86%

Retail salespeople 92%

Accountants 94%

Telemarketeers 99%

Source: C. Frey & M. Osborne (2013) 'The future of employment: How susceptible are Jobs to Computerisation?'

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resigning to move job reaching a post-financial crisis high of 1.126 million over the year to Q4 2016. If sustained, this should support firmer pay growth.

Meanwhile, further increases in the National Living Wage, which is predicted by the OBR to rise by just over 5% annually in each of the three years to 2020, will provide an impetus, if a small one, to total pay growth (it is estimated that the proportion of employees earning the national minimum or living wage will rise from 6% in 2015 to 15% in 2020).14 And the post-Brexit political environment may encourage a more interventionist attitude from policymakers in terms of boosting pay. However, the consequences of any moves in this direction are likely to be more distributional in nature than result in expanding the total earnings ‘pie’.

Key labour market forecasts

2014 2015 2016 2017 2018 2019 2020

Labour supply

Level, 000s 32,783 33,078 33,375 33,523 33,716 33,862 33,956

Annual % change 0.8 0.9 0.9 0.4 0.6 0.4 0.3

Employment levels (000s)

Total 30,757 31,297 31,741 31,930 31,887 31,902 32,008

Employees in employment 26,199 26,723 26,974 27,064 27,023 27,036 27,126

Self-employment 4,558 4,574 4,767 4,866 4,864 4,866 4,882

Employment, annual % change

Total 2.4 1.8 1.4 0.6 -0.1 0.0 0.3

Employees in employment 1.6 2.0 0.9 0.3 -0.2 0.0 0.3

Self-employment 6.9 0.4 4.2 2.1 0.0 0.0 0.3

Productivity (output per person employed)

Annual % change 0.7 0.4 0.4 1.2 1.3 1.4 1.5

Unemployment

Levels

LFS, 000s 2,026 1,781 1,634 1,594 1,829 1,960 1,948

Claimant count, 000s 1,037 799 776 747 864 930 924

Rate

LFS 6.2 5.4 4.9 4.8 5.4 5.8 5.7

Claimant count 3.0 2.3 2.2 2.1 2.4 2.6 2.6

Earnings, annual % change

Nominal 1.3 2.5 2.5 2.7 2.8 2.8 2.8

Real -0.1 2.5 1.9 -0.1 0.5 1.1 0.8

Sources: ONS, EY ITEM Club

14 Stephen Clarke and Conor D’Arcy, ‘Low Pay Britain 2016’, Resolution Foundation, October 2016. http://www.resolutionfoundation.org/app/uploads/2016/10/Low-Pay-Britain-2016.pdf

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With the compositional effects described in Section 2 continuing to fade, we do expect average earnings growth to pick up, but only marginally, to around 2¾% this year, with pay continuing to rise at a similar rate through 2018 and 2019. Consequently, prospects for growth in real, inflation-adjusted, pay look grim. We think that rises in consumer prices in both 2017 and 2018 will be close to growth in cash pay, implying negligible growth in real average earnings and contributing to a sharp slowdown in consumer spending growth.

4. Conclusions

Our analysis suggests that the UK labour market faces a rockier period than of late over the next few years. Pay growth seems unlikely to break out of the subdued pace seen since 2010. But the compensation to household incomes offered over that period by ever more people in work looks set to fade as the consequences of a slowdown in economic growth bite.

The extent of the likely deterioration shouldn’t be overdone. A forecast rise in the unemployment rate to 5½-6% will still compare very favourably with the positon over much of the last 40 years. And some likely developments in the jobs market, notably a slowdown in pace at which the supply of workers expands, could trigger some favourable moves in what has long been a bug-bear of the UK economy – very weak productivity growth.

So what does this mean for the wider economy and the corporate sector in particular? For one, it reinforces our view that monetary policy will see no shift until well into 2018. With the gap between actual unemployment and the Bank’s estimate of the equilibrium rate likely to widen in an unfavourable direction and pay growth set to stay weak, jobs market developments seem unlikely to provide much meat for the hawks on the Monetary Policy Committee.

The implications for fiscal policy are downbeat. While an environment of higher inflation can deliver a net boost to the public finances, this depends crucially on cash wages rising in response and so boosting the nominal tax base.15 But with the structural headwinds facing pay growth and the dampening effect of rising unemployment, growth in wages is forecast to remain historically weak, which is bad news for income tax receipts.

That said, having reined back its forecast for earnings growth in recent fiscal events, the OBR’s expectations now look more plausible, so the scope for downside surprises should be limited. And following the U-turn over tax changes for the self-employed announced in the March 2017 Budget, the forthcoming election may give a new government more flexibility to adjust the tax system to reflect shifts in forms of employment.

For companies, a continuation of low wage growth will, in some respects, be good news for bottom lines under pressure from the rising cost of raw materials and other inputs. But the corollary of sagging workers’ spending power – weaker domestic demand – won’t be helpful, particularly for consumer-facing firms. Meanwhile, the likelihood that developments in demographics and migration mean that growth in the availability of workers won’t be as bountiful as in the past may compel more focus on investment in capital equipment and the training and development of existing workforces. Among the clouds surrounding the UK’s jobs outlook, there may be some silver linings.

15 See Box 4.3 of Office for Budget Responsibility, ‘Economic and fiscal outlook’, March 2011. http://budgetresponsibility.org.uk/docs/dlm_uploads/Autumn2011EFO_web_version138469072346.pdf

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2004 2006 2008 2010 2012 2014 2016 2018 2020

Average earnings* CPI inflation

UK: Average earnings & inflation% year

Source : EY ITEM Club

Forecast

*National Accounts measure

EY 17

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